Michael Hicks
The inflation data this week pointed to continued high prices, despite an announcement by the Federal Reserve of significant efforts to end inflation this year. At the same time, more than one economist suggested that we face higher recession risks this year. Both of these developments are worrying, and I think there is cause for concern both on inflation and recession risks. But, there is also reason for some optimism, along with plenty of uncertainty.
It is clear today that the American Rescue Plan passed by Congress was too big, and helped fuel the inflation we now see. Last March I wrote in this column that the bill could’ve been about half the size and achieve most of the same goals. I was not alone in that sentiment, but I also wrote that one of the lessons of the Great Recession is that too little stimulus is also a significant risk.
What was not clear in March 2021 was that household savings were much healthier than expected, and that labor markets were performing better than the preliminary data suggested. In that same column, I noted that labor markets were still several years away from full recovery. We still have not recovered the jobs lost in the pandemic and may not catch up to trend for several years.
Someone acting in good faith in early 2021 could’ve judged the American Rescue Plan as right sized. And, yes, I know that the act of admitting that someone who disagreed with you could be acting in good faith is a relic of the distant past, but I’m old-fashioned like that.
The inflation we now see is measured in higher prices for goods and services. That measurement is imperfect because it captures not only inflation, but also non-inflationary events like a war in Ukraine or an uneven restart of factory production after COVID. So, in real time, it is difficult to know precisely how many individual price increases are due to factors that are not really inflation, and how many are traditional inflation.
Making a distinction between some transient shock to prices and actual long-term inflation is important in deciding how to deal with the problem. If prices at the gas pump and grocery are due to a short-term spike in gasoline prices due to a foreign war, then almost nothing the Federal Reserve does can reduce prices. Conversely, if all the price increases for gasoline, food, movies and restaurants is due to excess demand by consumers, the Federal Reserve can slow inflation.
The March inflation data signaled some of both. The data on March inflation was collected in the early weeks of the month as the Russo-Ukrainian War led to large increases in gasoline and other commodities. That data showed a large annual increase of inflation, at 8.5%. However, other measures of inflation that focus only on parts of the economy that aren’t susceptible to volatile price changes saw a slower increase.
In the month since early March, gasoline prices have retreated modestly and the Federal Reserve’s first rate hike kicked in. With the Fed promising at least six more interest rate increases this year, it is altogether possible that the March inflation data was the peak of this inflationary cycle. Further bolstering the likelihood that inflation will ease is the fact that household savings is now back nearly to pre-pandemic levels. The urgent spending in the summer and fall of 2021 won’t be repeated this summer.
Of course, the way you moderate inflation is by slowing the growth of the economy. The Fed does this by tightening the supply of loanable money. The most visible way of doing this is by raising interest rates for banks. This increase in rates then spreads through the economy, affecting consumer and business loans. Thus, higher mortgage or car loan rates, higher credit card payments on the same debt, and higher costs for business all lead to a slowing economy.
Right now, labor markets are very tight, and few workers who desire to work will be unable to find a job. Still, for a full six months, inflation has risen more quickly than wages. Lower inflation-adjusted wages won’t lure potential employees back into the workplace. This is especially true for workers who struggle with child care, which has seen very substantial price increases.
Very tight labor markets, combined with only modestly higher interest rates, should mean the Fed can slow inflation without tipping the economy into a recession. Of course, that has been the goal of every effort to slow inflation, including all those that did end in a recession. With the Fed tightening money supply, the risks of a recession are higher.
There are a few wrinkles in all this calculus that the Fed must consider without having any really good evidence. The first of these is the continuing war in Ukraine and its potential impact on our economy. There’s a wide range of bad possibilities and very few good ones coming from Eastern Europe. In many ways, Americans should be viewing today’s risks very similarly to those we experienced with Iraq in 1990. We’d be better off preparing for cascades of bad news.
Beyond the risks of war are the unknown responses of consumers. If you are in your later 50s, you remember inflation. If you are in your early 60s or older, you probably lived with inflation as part of your business and household decisions. The wisdom of this experience puts the current inflation into context, muting some of its long-term risks.
If you are under 55, you likely have little recollection of inflation, and if you are under 50, you have none. The problem for the Fed is that most home mortgages and auto loans, along with most credit card debt, is held by people under 50. Their response to higher interest rates cannot be well known, simply because we’ve only had one long period of rate increase since the early 1980s.
In summary, the very best hopes for the economy over the next 12 months are moderating growth with significantly slower inflation. At the other end would be a period of much slower growth with continued inflation, or stagflation. The ability of policy makers at the Fed to fully understand the economy in real time is questionable, so something in-between is most likely. Still, it would be imprudent to discount either extreme.
